SECURITIES AND EXCHANGE COMMISSION
| ☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended March 31, 2020
| ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from
to
Commission File Number:
001-36409
(Exact name of registrant as specified in its charter)
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(State or other jurisdiction of | | |
(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, including area code: (604)
806-3366
Securities registered pursuant to Section 12(b) of the Act:
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Common Stock, $0.01 par value | | | | |
6.625% Series A Cumulative Redeemable
Preferred Stock, $0.01 par value per share | | | | |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ☒
No
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation
S-T
(§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).
☒
Yes No
☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a
non-accelerated
filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule
12b-2
of the
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| | | | Smaller reporting company | | ☐ |
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If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act
☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule
12b-2
of the Exchange Act).
Yes
☐
☒
No
The number of shares of Common Stock, $0.01 par value, of the registrant outstanding at May 4, 2020 was 47,571,517.
The following table summarizes the Company’s allocation of the purchase price of assets acquired and liabilities assumed during the three months ended March 31, 2019 (in thousands):
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| | $ | | |
Buildings and improvements | | | | |
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Accounts payable and other liabilities | | | | ) |
Lease intangible liabilities | | | | ) |
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| | $ | | |
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Sale of Real Estate Property
On February 7, 2019, the Company sold the Plaza 25 property in Denver, Colorado for $17.9 million. No gain or loss was recognized on the sale as the property was carried at fair value less cost to sell on the date of disposition.
On May 10, 2019, the Company entered into a purchase and sale agreement to sell a land parcel at the Circle Point property for $6.5 million. The Company determined that the land parcel met the criteria for classification as held for sale as of March 31, 2020 and December 31, 2019. The transaction is anticipated to close in the third quarter of 2020, subject to customary closing conditions. As of March 31, 2020, the Company has received a $0.5 million
non-refundable
deposit.
The property has been classified as held for sale as of March 31, 2020 and December 31, 2019 (in thousands):
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Real estate properties, net | | $ | | | | $ | | |
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| | $ | | | | $ | | |
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Accounts payable, accrued expenses, deferred rent and tenant rent deposits | | $ | | ) | | $ | | ) |
| | | | | | | | | |
Liabilities related to assets held for sale | | $ | | ) | | $ | | ) |
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In September 2019, the Company entered into
a
five-year Interest Rate Swap for a notional amount of $50.0 million. Pursuant to the Interest Rate Swap, the Company will pay a fixed rate of approximately 1.27% of the notional amount annually, payable monthly, and receive floating rate
30-day
LIBOR payments. Accordingly, the fair value of the Interest Rate Swap has been classified as a Level 2 fair value measurement.
The Interest Rate Swap has been designated and qualifies as a cash flow hedge and has been recognized on the consolidated balance sheets at fair value. Gains and losses resulting from changes in the fair value of derivatives that have been designated and qualify as cash flow hedges are reported as a component of other comprehensive income (loss) and reclassified into earnings in the periods during which the hedged forecasted transaction affects earnings.
As of March 31, 2020, the Interest Rate Swap was reported as a liability at its fair value of approximately $2.0 million, which is included in other liabilities on the Company’s consolidated balance sheet. For the three months ended March 31, 2020 the amount of realized losses reclassified to interest expense due to payments received by the swap counterparty were nominal.
As of December 31, 2019, the Interest Rate Swap was reported as an asset at its fair value of approximately $0.7 million, which is included in other assets on the Company’s consolidated balance sheet.
Cash, Cash Equivalents, Restricted Cash, Rents Receivable, Accounts Payable and Accrued Liabilities
The Company estimates that the fair value approximates carrying value due to the relatively short-term nature of these instruments.
Fair Value of Financial Instruments Not Carried at Fair Value
With the exception of fixed rate mortgage loans payable, the carrying amounts of the Company’s financial instruments approximate their fair value. The Company determines the fair value of its fixed rate mortgage loan payable based on a discounted cash flow analysis using a discount rate that approximates the current borrowing rates for instruments of similar maturities. Based on this, the Company has determined that the fair value of these instruments was $610.3 million and $576.9 million as of March 31, 2020 and December 31, 2019, respectively. Accordingly, the fair value of mortgage loans payable have been classified as Level 3 fair value measurements.
7. Related Party Transactions
Administrative Services Agreement
For the three months ended March 31, 2020 and 2019, the Company earned $0.1 million and $0.1 million, respectively, in administrative services performed for Second City Real Estate II Corporation and its affiliates (“Second City”).
On July 31, 2019, an indirect, wholly-owned subsidiary of the Company entered into an
(the “Administrative Services Agreement”) with Clarity Real Estate III GP, Limited Partnership and Clarity Real Estate Ventures GP, Limited Partnership (together, “Clarity”), entities affiliated with principals of Second City and officers of the Company. Pursuant to the Administrative Services Agreement, the Company will provide various administrative services and support to the related entities managing the Clarity funds. During the three months ended March 31, 2020, the amounts earned by the Company for the administrative services performed for Clarity were nominal.
The Company is focused on acquiring, owning and operating high-quality office properties for lease to a stable and diverse tenant base. Our properties have both full-service gross and net leases which are generally classified as operating leases. Rental income related to such leases is recognized on a straight-line basis over the remaining lease term. The Company’s total revenue includes fixed base rental payments provided under the lease and variable payments which principally consist of tenant expense reimbursements for certain property operating expenses.
Future minimum lease payments to be received by the Company as of March 31, 2020 under
non-cancellable
operating leases for the next five years and thereafter are as follows (in thousands):
The Company’s leases may include various provisions such as scheduled rent increases, renewal options and termination options. The majority of the Company’s leases include defined rent increase rather than variable payments based on an index or unknown rate. One state government tenant currently has the exercisable right to terminate their lease if the applicable state legislature does not appropriate rent in its annual budget. The Company has determined that the occurrence of any government tenant not being appropriated the rent in the applicable annual budget is a remote contingency and accordingly recognizes lease revenue on a straight-line basis over the respective lease term. This tenant represents approximately 7.2% of the Company’s total future minimum lease payments as of March 31, 2020.
As a lessee, the Company has ground and office leases which
are classified as operating and financing leases
. As of March
31
,
2020
, these leases had remaining terms of
2
to
68
years and a weighted average remaining lease term of
56
years.
R
ight-of-use assets and lease liabilities have been included within other assets and other liabilities on the Company’s condensed consolidated balance sheet as follows (in thousands):
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Right-of-use asset – operating leases | | $ | | | | $ | | |
Lease liability – operating leases | | $ | | | | $ | | |
Right-of-use asset – financing leases | | $ | | | | $ | | |
Lease liability – financing leases | | $ | | | | $ | | |
Operating lease expense for each of the three months ended March 31, 2020 and March 31, 2019 was $0.2 million. Financing lease expense for the three months ended March 31, 2020 was nominal. The Company did not have any financing leases as of the three months ended March 31, 2019.
Future minimum lease payments to be paid by the Company as a lessee for operating and financing leases as of March 31, 2020 for the next five years and thereafter are as follows (in thousands):
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| | $ | | | | $ | | |
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Total future minimum lease payments | | | | | | | | |
| | | | ) | | | | ) |
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| | $ | | | | $ | | |
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9. Commitments and Contingencies
The Company is obligated under certain tenant leases to fund tenant improvements and the expansion of the underlying leased properties.
Under various federal, state and local laws, ordinances and regulations relating to the protection of the environment, a current or previous owner or operator of real estate may be liable for the cost of removal or remediation of certain hazardous or toxic substances disposed, stored, generated, released, manufactured or discharged from, on, at, under, or in a property. As such, the Company may be potentially liable for costs associated with any potential environmental remediation at any of its formerly or currently owned properties.
The Company believes that it is in compliance in all material respects with all federal, state and local ordinances and regulations regarding hazardous or toxic substances. Management is not aware of any environmental liability that it believes would have a material adverse impact on the Company’s financial position or results of operations. Management is unaware of any instances in which the Company would incur significant environmental costs if any or all properties were sold, disposed of or abandoned. However, there can be no assurance that any such
non-compliance,
liability, claim or expenditure will not arise in the future.
The Company is involved from time to time in lawsuits and other disputes which arise in the ordinary course of business. As of March 31, 2020
,
management believes that these matters will not have a material adverse effect, individually or in the aggregate, on the Company’s financial position or results of operations.
Repurchased shares of common stock will be classified as authorized and unissued shares. The Company recognizes the cost of shares of common stock it repurchases, including direct costs incurred, as a reduction in stockholders’ equity. Such reductions of stockholders equity due to the repurchases of shares of common stock will be applied first, to reduce common stock in the amount of the par value associated with the shares of common stock repurchased and second, to reduce additional
paid-in
capital by the amount that the purchase price for the shares of common stock repurchased exceed the par value.
During the three months ended March 31, 2020, the Company completed the repurchase of 1,451,249 shares of its common stock for approximately $11.6 million. There were 0 shares repurchased during the three months ended March 31, 2019.
Common Stock and Common Unit Distributions
On March 25, 2020, the Company’s Board of Directors approved and the Company declared a cash dividend distribution of $0.15 per
share for the quarterly period ended March 31, 2020. The dividend was paid subsequent to quarter end on April 24, 2020 to common stockholders and common unitholders of record as of the close of business on April 9, 2020, resulting in an aggregate payment of $7.8 million.
Preferred Stock Distributions
On March 25, 2020 the Company’s Board of Directors approved and the Company declared a cash dividend of $0.4140625
per share of the Company’s 6.625% Series A Preferred Stock (“Series A Preferred Stock”)
for an aggregate amount of $1.9 million for the quarterly period ended March 31, 2020. The dividend was paid subsequent to quarter end on April 24, 2020
to the holders of record of Series A Preferred Stock as of the close of business on
April 9, 2020.
The Company has an equity incentive plan (“Equity Incentive Plan”) for executive officers, directors and certain
non-executive
employees, and with approval of the Board of Directors, for subsidiaries and their respective affiliates. The Equity Incentive Plan provides for grants of restricted common stock, restricted stock units, phantom shares, stock options, dividend equivalent rights and other equity-based awards (including LTIP Units), subject to the total number of shares available for issuance under the plan. The Equity Incentive Plan is administered by the compensation committee of the Board of Directors (the “Plan Administrator”).
On May 2, 2019, the Company’s stockholders approved an amendment to the Equity Incentive Plan increasing the maximum number of shares of common stock that may be issued under the Equity Incentive Plan from 1,263,580 shares to 2,263,580 shares. To the extent an award granted under the Equity Incentive Plan expires or terminates, the shares subject to any portion of the award that expires or terminates without having been exercised or paid, as the case may be, will again become available for the issuance of additional awards.
On January 27, 2020, each of the Board of Directors and the Compensation Committee approved a new form of
performance-based restricted unit award agreement (the “Performance RSU Award Agreement”) that will be used to grant performance-based restricted stock unit awards (“Performance RSU Awards”) pursuant to the Equity Incentive Plan. The Performance RSU Awards are based upon the total stockholder return (“TSR”) of the Company’s common stock over a three-year measurement period beginning January 1, 2020 and ending on December 31, 2022 (the “Measurement Period”) relative to the TSR of the companies in the SNL US REIT Office
index as of January 2, 2020 (the “2020 RSU Peer Group”). The payouts under the Performance RSU Awards are evaluated on a sliding scale as follows: TSR below the 30th percentile of the 2020 RSU Peer Group would result in a 50% payout; TSR at the 50th percentile of the 2020 RSU Peer Group would result in a 100% payout; and TSR at or above the 75th percentile of the 2020 RSU Peer Group would result in a 150% payout. Payouts are mathematically interpolated between these stated percentile targets, subject to a 150% maximum.
To the extent earned, the payouts of the Performance RSU Awards are intended to be settled in the form of shares of the Company’s common stock, pursuant to the Equity Incentive Plan. Upon satisfaction of the vesting conditions, dividend equivalents in an amount equal to all regular and special dividends declared with respect to the Company’s common stock during each annual measurement period during the Measurement Period are determined and paid on a cumulative, reinvested basis over the term of the applicable Performance RSU Award, at the time such award vests and based on the number of shares of the Company’s common stock that are earned.
During the three months ended March 31, 2020, 147,050 restricted stock units (“RSUs”) were granted to executive officers, directors and certain
non-executive
employees with a fair value of $2.0 million. The
RSU
awards will vest in three equal, annual installments on each of the first three anniversaries of the date of grant. For the three months ended March 31, 2020
,
the Company recognized net compensation expense of $0.5 million related to the RSUs. For the three months ended March 31, 2019, the Company recognized net compensation expense of $0.4 million related to the RSUs.
During the three months ended March 31, 2020, 97,500
Performance RSU Awards were granted to executive officers with a fair value
of $1.3
million. The Performance RSU Awards will vest on the last day of
the three-year measurement period of January 1, 2020 through December 31, 2022.
For the three months ended March 31, 2020, the Company recognized net compensation expense of $0.1 million related to the Performance RSU Awards. There was
0
compensation expense related to the Performance RSU Awards for the three months ended March 31, 2019.
Subsequent to quarter end through May 5, 2020, the Company settled on the repurchase of 5,872,328 shares of its common stock for approximately $48.9 million.
The recent
COVID-19
pandemic has caused significant disruption in global financial markets and economies. The Company is closely monitoring the impact of the recent
COVID-19
pandemic on all aspects of its business and geographies, including government actions in response to the outbreak and the impact on its tenants. While the Company did not experience any significant disruptions during the three months ended March 31, 2020, as a result of the
COVID-19
pandemic or governmental or tenant actions in response thereto, the extent to which
COVID-19
will impact the Company is highly uncertain and cannot be predicted with confidence at this time.
Since March 2020, the Company received certain rent relief requests, most often in the form of rent deferral requests, as a result of
COVID-19.
The Company is evaluating each tenant rent relief request on an individual basis, considering a number of factors. Not all tenant requests will ultimately result in modification agreements, nor is the Company forgoing its contractual rights under its lease agreements.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis is based on, and should be read in conjunction with, the condensed, consolidated financial statements and the related notes thereto of the City Office REIT, Inc. contained in this Quarterly Report on Form
10-Q
(this “Report”).
As used in this section, unless the context otherwise requires, references to “we,” “our,” “us,” and “our company” refer to City Office REIT, Inc., a Maryland corporation, together with our consolidated subsidiaries, including City Office REIT Operating Partnership L.P., a Maryland limited partnership, of which we are the sole general partner and which we refer to in this section as our Operating Partnership, except where it is clear from the context that the term only means City Office REIT, Inc.
Cautionary Statement Regarding Forward-Looking Statements
This quarterly report on Form
10-Q,
including “Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition,” contains both historical and forward-looking statements. All statements, other than statements of historical fact are, or may be deemed to be, forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We have used the words “approximately,” “anticipate,” “assume,” “believe,” “budget,” “contemplate,” “continue,” “could,” “estimate,” “expect,” “future,” “intend,” “may,” “outlook,” “plan,” “potential,” “predict,” “project,” “seek,” “should,” “target,” “will” and similar terms and phrases to identify forward-looking statements in this Report. All of our forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those that we are expecting, including:
| | • | adverse economic or real estate developments in the office sector or the markets in which we operate; |
| | • | changes in local, regional, national and international economic conditions, including as a result of the recent COVID-19 pandemic; |
| | • | our inability to compete effectively; |
| | • | our inability to collect rent from tenants or renew tenants’ leases on attractive terms if at all; |
| | • | demand for and market acceptance of our properties for rental purposes; |
| | • | defaults on or non-renewal of leases by tenants; |
| | • | increased interest rates and any resulting increase in financing or operating costs; |
| | • | decreased rental rates or increased vacancy rates; |
| | • | our failure to obtain necessary financing or access the capital markets on favorable terms or at all; |
| | • | changes in the availability of acquisition opportunities; |
| | • | availability of qualified personnel; |
| | • | our inability to successfully complete real estate acquisitions or dispositions on the terms and timing we expect, or at all; |
| | • | our failure to successfully operate acquired properties and operations; |
| | • | changes in our business, financing or investment strategy or the markets in which we operate; |
| | • | our failure to generate sufficient cash flows to service our outstanding indebtedness; |
| | • | environmental uncertainties and risks related to adverse weather conditions and natural disasters; |
| | • | our failure to qualify and maintain our status as a real estate investment trust (“REIT”); |
| | • | government approvals, actions and initiatives, including the need for compliance with environmental requirements or actions in response to the recent global COVID-19 pandemic; |
| | • | outcome of claims and litigation involving or affecting us; |
| | • | financial market fluctuations; |
| | • | changes in real estate, taxation and zoning laws and other legislation and government activity and changes to real property tax rates and the taxation of REITs in general; and |
| | • | other factors described in our news releases and filings with the Securities and Exchange Commission (the “SEC”), including but not limited to those described in our Annual Report on Form 10-K for the year ended December 31, 2019 under the heading “Risk Factors” and in our subsequent reports filed with the SEC. |
The forward-looking statements contained in this Report are based on historical performance and management’s current plans, estimates and expectations in light of information currently available to us and are subject to uncertainty and changes in circumstances. There can be no assurance that future developments affecting us will be those that we have anticipated. Actual results may differ materially from these expectations due to the factors, risks and uncertainties described above, changes in global, regional or local political, economic, business, competitive, market, regulatory and other factors described in our news releases and filings with the SEC, including but not limited to those described in our Annual Report on Form
10-K
for the year ended December 31, 2019 under the heading “Risk Factors” and in our subsequent reports filed with the SEC, many of which are beyond our control. Should one or more of these risks or uncertainties materialize, or should any of our assumptions prove to be incorrect, our actual results may vary in material respects from what we may have expressed or implied by these forward-looking statements. We caution that you should not place undue reliance on any of our forward-looking statements. Any forward-looking statement made by us in this Report speaks only as of the date of this Report. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by applicable securities laws.
We were formed as a Maryland corporation on November 26, 2013. On April 21, 2014, we completed our initial public offering (“IPO”) of shares of common stock. We contributed the net proceeds of the IPO to our Operating Partnership in exchange for common units in our Operating Partnership. Both we and our Operating Partnership commenced operations upon completion of the IPO and certain related formation transactions.
As of March 31, 2020, we owned 25 properties comprised of 65 office buildings with a total of approximately 5.8 million square feet of net rentable area (“NRA”). As of March 31, 2020, our properties were approximately 92.2% leased.
Historically, most leases for our properties were on a full-service gross or net lease basis, and we expect to continue to use such leases in the future. A full-service gross lease generally has a base year expense “stop”, whereby we pay a stated amount of expenses as part of the rent payment while future increases (above the base year stop) in property operating expenses are billed to the tenant based on such tenant’s proportionate square footage in
the property. The property operating expenses are reflected in operating expenses; however, only the increased property operating expenses above the base year stop recovered from tenants are reflected as tenant recoveries in our statements of operations. In a triple net lease, the tenant is typically responsible for all property taxes and operating expenses. As such, the base rent payment does not include any operating expenses, but rather all such expenses are billed to or paid by the tenant. The full amount of the expenses for this lease type is reflected in operating expenses, and the reimbursement is reflected in tenant recoveries. All tenants in the Lake Vista Pointe, 2525 McKinnon, Sorrento Mesa and Canyon Park properties have triple net leases. Certain tenants at AmberGlen, Cherry Creek, Superior Pointe, Florida Research Park, Circle Point, The Quad, Cascade Station and Denver Tech have leases on a triple net basis. We are also a lessor for a fee simple ground lease at the AmberGlen property. All of our remaining leases are full-service gross leases.
Factors That May Influence Our Operating Results and Financial Condition
During the first quarter of 2020, the World Health Organization declared the
COVID-19
outbreak a pandemic. There have been mandates from international, federal, state and local authorities requiring forced closures of businesses and other facilities, and most of the markets in which our buildings are located are subject to some form of quarantine or
shelter-in-place
restrictions. These forced closures and restrictions have had a material adverse effect on the global economy and the regional U.S. economies in which we operate, including negatively impacting some of our tenants’ ability to pay their rent.
It is still too early to predict the extent and timing of the full impact on businesses from the severe dislocations caused by the effective shutdown of large segments of our economy. While the
COVID-19
pandemic did not have a meaningful impact on our financial results for the first quarter of 2020, we believe it is likely our future financial results will be adversely impacted by the
COVID-19
pandemic. Given the fluidity of the pandemic and its uncertain impact on economic activity, losses related to tenant financial difficulties are difficult to predict.
All of our buildings are open and continue to operate. We have adopted new policies and procedures to incorporate best practices for the safety of our tenants, our vendors and our employees. However, the usage of our assets in March and April of 2020 was significantly lower than normal due to the
COVID-19
pandemic. Usage of our assets for the remainder of 2020, however, depends on the duration of the
COVID-19
pandemic, which is difficult to estimate.
We believe that some of the industries that will be most impacted by
COVID-19
are coworking, retail, restaurant and café, travel and accommodation, live event related and energy. We generally have limited exposure to these industries, with these sectors comprising approximately 3% of our portfolio by square footage. However, the impact of
COVID-19
extends to all sectors of the U.S. economy and as such, we expect that tenants outside of these select industries will also face significant challenges. Rating agencies have downgraded the credit rating and outlook of many businesses, including two of our ten largest tenants.
Through May 4, 2020, we have collected approximately 98% of our contractually required base rents from our tenants for the month of April 2020. We expect that the rate of collections in May 2020 and future months may be lower, as the length of the economic downturn continues to impact tenants. We have received rent relief requests from certain tenants, and we have developed dedicated teams and processes to evaluate
non-payments
and rent relief requests. We believe many of these requests received were from tenants who have the ability to pay rent and were seeking opportunistic deferral opportunities. We are working efficiently to find tailored resolutions in each case where warranted, including potential deferrals of rent, lease term extensions in lieu of short term rent relief, temporary percentage rent opportunities for hospitality entities, or, in limited circumstances, rent abatement particularly when the tenant is viewed as an amenity to the building. We assume we will incur losses due to tenants that default on their leases, file for bankruptcy and/or otherwise experience significant financial difficulty as a result of the
COVID-19
pandemic, but the extent of those losses is difficult to predict.
We also believe that leasing activity has been and will continue to be impacted by
COVID-19.
We expect that we will experience slower than originally anticipated speculative new leasing, which we expect will be partially offset by higher renewal activity. Overall, this would reduce our anticipated rental revenues. Because construction activities have generally been classified as essential activities throughout our markets during the
COVID-19
pandemic, we do not currently expect meaningful delays in customers taking occupancy under recently signed leases.
Strategically, we have made adjustments to our business operations as a result of
COVID-19.
We have ceased acquisition activities, allocated capital towards our share repurchase program, adjusted our common stock dividend and are operating with lower leverage and higher levels of liquidity. For a discussion of the impact of the
COVID-19
pandemic on our liquidity and balance sheet, see “Liquidity and Capital Resources” below.
The situation surrounding
COVID-19
remains fluid and we will continue to monitor and actively manage our response in collaboration with tenants, government officials and other third parties to optimally position the Company.
We focus on owning and acquiring office properties in our target markets. Our target markets generally possess what we believe are favorable economic growth trends, growing populations with above-average employment growth forecasts, a large number of government offices, large international, national and regional employers across diversified industries, are generally
low-cost
centers for business operations, and exhibit favorable occupancy trends. We utilize our management’s market-specific knowledge and relationships as well as the expertise of local real estate operators and our investment partners to identify acquisition opportunities that we believe will offer cash flow stability and long-term value appreciation. Our target markets are attractive, among other reasons, because we believe that ownership is often concentrated among local real estate operators that typically do not benefit from the same access to capital as public REITs and there is a relatively low level of participation of large institutional investors. We believe that these factors result in attractive pricing levels and risk-adjusted returns.
Rental Revenue and Tenant Recoveries
The amount of net rental revenue generated by our properties will depend principally on our ability to maintain the occupancy rates of currently leased space and to lease currently available space and space that becomes available from lease terminations. The amount of rental revenue generated also depends on our ability to maintain or increase rental rates at our properties. We believe that the average rental rates for our portfolio of properties are generally
in-line
or slightly below the current average quoted market rates. Negative trends in one or more of these factors could adversely affect our rental revenue in future periods. Future economic downturns or regional downturns affecting our markets or submarkets or downturns in our tenants’ industries that impair our ability to renew or
re-let
space and the ability of our tenants to fulfill their lease commitments, as in the case of tenant bankruptcies, could adversely affect our ability to maintain or increase rental rates at our properties. In addition, growth in rental revenue will also partially depend on our ability to acquire additional properties that meet our investment criteria.
Our operating expenses generally consist of utilities, property and ad valorem taxes, insurance and site maintenance costs. Increases in these expenses over tenants’ base years (until the base year is reset at expiration) are generally passed along to tenants in our full-service gross leased properties and are generally paid in full by tenants in our net leased properties.
Conditions in Our Markets
Positive or negative changes in economic or other conditions in the markets we operate in, including state budgetary shortfalls, employment rates, natural hazards and other factors, may impact our overall performance. In addition, the recent
COVID-19
pandemic has caused significant disruption in global financial markets and economies. This global disruption could have a material impact on the markets in which we operate, our tenants and our ability to successfully execute our business strategy. The extent to which
COVID-19
will impact the Company is highly uncertain and cannot be predicted with confidence at this time. Refer to “Item 1A. Risk Factors” in this Report for further information.
Summary of Significant Accounting Policies
The interim condensed consolidated financial statements follow the same policies and procedures as outlined in the audited consolidated financial statements for the year ended December 31, 2019 included in our Annual Report on Form
10-K
for the year ended December 31, 2019.
Comparison of Three Months Ended March 31, 2020 to Three Months Ended March 31, 2019
Rental and Other Revenues.
Revenue includes net rental income, including parking, signage and other income, as well as the recovery of operating costs and property taxes from tenants. Rental and other revenues increased $3.0 million, or 8%, to $40.1 million for the three months ended March 31, 2020 compared to $37.1 million for the three months ended March 31, 2019. Of this increase, $0.9 million was attributable to the acquisition of Canyon Park in February 2019, $0.9 million was attributable to the acquisition of Cascade Station in June 2019 and $1.4 million was attributable to the acquisition of 7601 Tech, part of our Denver Tech property, in September 2019. Revenue from Park Tower increased by $0.2 million as a result of increased average occupancy over the prior year and 190 Office Center increased by $0.3 million, primarily as a result of a termination fee received in the current year. Partially offsetting these increases, Plaza 25 decreased overall revenue by $0.2 million due to the sale of the property in February 2019 and Logan Tower decreased overall revenue by $0.3 million due to the sale of the property in December 2019. In addition, revenue from the Sorrento Mesa portfolio decreased by $0.2 million as a result of the sale of the 10455 Pacific Center building in May 2019. The remaining properties’ revenues were flat in comparison to the prior year.
Total Operating Expenses.
Total operating expenses consist of property operating expenses, general and administrative expenses and depreciation and amortization. Total operating expenses increased by $1.8 million, or 6%, to $32.4 million for the three months ended March 31, 2020, from $30.6 million for the three months ended March 31, 2019, primarily due to the acquisitions described above. Total operating expenses increased by $0.6 million, $0.7 million and $1.1 million, respectively, from the acquisitions of Canyon Park, Cascade Station and 7601 Tech properties. Plaza 25 operating expenses decreased by $0.2 million due to its sale in February 2019 and Logan Tower operating expenses decreased by $0.3 million due to its sale in December 2019. Operating expenses for the Sorrento Mesa portfolio decreased by $0.3 million due to the sale of the 10455 Pacific Center building in May 2019. General and administrative expenses increased by approximately $0.5 million, primarily attributable to higher payroll costs. The remaining operating expenses were marginally lower in comparison to the prior-year period.
Property Operating Expenses.
Property operating expenses are comprised mainly of building common area and maintenance expenses, insurance, property taxes, property management fees, as well as certain expenses that are not recoverable from tenants, the majority of which are related to costs necessary to maintain the appearance and marketability of vacant space. In the normal course of business, property expenses fluctuate and are impacted by various factors including, but not limited to, occupancy levels, weather, utility costs, repairs, maintenance and
re-leasing
costs. Property operating expenses increased by $0.9 million, or 6%, to $14.7 million for the three months ended March 31, 2020, from $13.8 million for the three months ended March 31, 2019. The increase in property operating expenses was primarily due to the acquisitions described above. The acquisition of the Canyon Park, Cascade Station and 7601 Tech properties contributed an additional $0.2 million, $0.3 million, and $0.6 million, respectively, in additional property operating expenses. Partially offsetting these increases, Plaza 25 decreased by $0.2 million due to the sale of that property in February 2019, the Sorrento Mesa portfolio decreased by $0.1 million due to the sale of the 10455 Pacific Center building in May 2019, and Logan Tower decreased by $0.2 million due to the sale of that property in December 2019. The remaining property operating expenses aggregate to an increase of $0.3 million in comparison to the prior-year period.
General and Administrative.
General and administrative expenses are comprised of public company reporting costs and the compensation of our management team and board of directors, as well as
non-cash
stock-based compensation expenses. General and administrative expenses increased $0.5 million, or 21%, to $2.8 million for the three months ended March 31, 2020, from $2.3 million for the three months ended March 31, 2019. The increase was primarily attributable to higher payroll costs.
Depreciation and Amortization.
Depreciation and amortization increased $0.6 million, or 4%, to $15.0 million for the three months ended March 31, 2020, from $14.4 million for the three months ended March 31, 2019, primarily due to the addition of the Canyon Park, Cascade Station and 7601 Tech properties. These increases were partially offset by a decrease at Plaza 25, Logan Tower and the 10455 Pacific Center building of the Sorrento Mesa property due to the sale of those properties.
Interest expense decreased $0.8 million, or 11%, to $6.7 million for the three months ended March 31, 2020, from $7.5 million for the three months ended March 31, 2019. The decrease was primarily attributable to a decrease of $1.1 million of interest expense on our Unsecured Credit Facility (as defined herein) as a result of the repayments using the net proceeds of the equity raises during the year. Interest expense also decreased by $0.2 million due to the negotiated reduction in interest rate on four mortgages in the second half of 2019. Partially offsetting these decreases, interest expense for the Canyon Park and Cascade Station property level debt increased by $0.3 million, and $0.2 million, respectively, due to the acquisitions of those properties in 2019.
Comparison of Three Months Ended March 31, 2020 to Three Months Ended March 31, 2019
Cash, cash equivalents and restricted cash were $164.8 million and $37.0 million as of March 31, 2020 and March 31, 2019, respectively.
Cash flow from operating activities.
Net cash provided by operating activities increased by $7.9 million to $10.7 million for the three months ended March 31, 2020 compared to $2.8 million for the same period in 2019. The increase was primarily attributable to increased operating cash flows from acquired properties, including changes in working capital.
Cash flow to investing activities.
Net cash used in investing activities decreased by $31.4 million to $5.3 million for the three months ended March 31, 2020 compared to $36.7 million for the same period in 2019. The decrease in cash used in investing activities was primarily due to no acquisitions or dispositions of real estate during the three months ended March 31, 2020 compared to aggregate $51.1 million of acquisitions and aggregate $17.4 million of dispositions for the same period in 2019.
Cash flow from financing activities.
Net cash provided by financing activities increased by $34.1 million to $71.9 million for the three months ended March 31, 2020 compared to $37.8 million for the same period in 2019. Cash flow provided by financing activities increased primarily due to higher net proceeds from our Unsecured Credit Facility borrowings for the three months ended March 31, 2020 compared to the same period in 2019, partially offset by common stock repurchases during the three months ended March 31, 2020.
We believe we have access to multiple sources of capital to fund our long-term liquidity requirements, including the incurrence of additional debt and the issuance of additional equity securities. However, we cannot assure you that this is or will continue to be the case. Our ability to incur additional debt is dependent on a number of factors, including our degree of leverage, the value of our unencumbered assets and borrowing restrictions that may be imposed by lenders. Our ability to access the equity capital markets is dependent on a number of factors as well, including general market conditions for REITs and market perceptions about us.
Contractual Obligations and Other Long-Term Liabilities
The following table provides information with respect to our commitments as of March 31, 2020, including any guaranteed or minimum commitments under contractual obligations. The table does not reflect available debt extension options.
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Principal payments on mortgage loans | | $ | | | | $ | | | | $ | | | | $ | | | | $ | | |
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Tenant-related commitments | | | | | | | | | | | | | | | | | | | | |
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| | $ | | | | $ | | | | $ | | | | $ | | | | $ | | |
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| (1) | Contracted interest on the floating rate borrowings under our Unsecured Credit Facility was calculated based on the balance and interest rate at March 31, 2020. Contracted interest on the Term Loan was calculated based on the Interest Rate Swap rate fixing the LIBOR component of the borrowing rate to approximately 1.27%. |
Off-Balance
Sheet Arrangements
As of March 31, 2020, we had a $7 million letter of credit outstanding under our Unsecured Credit Facility to satisfy escrow requirements for a mortgage lender.
Substantially all of our office leases provide for real estate tax and operating expense escalations. In addition, most of the leases provide for fixed annual rent increases. We believe that inflationary increases may be at least partially offset by these contractual rent increases and expense escalations.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our future income, cash flows and fair values relevant to financial instruments are dependent upon prevailing market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates. We have used, and will use, derivative financial instruments to manage or hedge interest rate risks related to borrowings. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based upon their credit rating and other factors. See Note 6 to our consolidated financial statements in Item 1 of this Report for more information regarding our derivatives.
The primary market risk to which we are exposed is interest rate risk. Our primary interest rate exposure is LIBOR. We primarily use fixed interest rate financing to manage our exposure to fluctuations in interest rates. We consider our interest rate exposure to be minimal, because as of March 31, 2020, approximately $560.8 million, or 78.9%, of our debt had fixed interest rates and approximately $150 million, or 21.1%, had variable interest rates. Of the $150 million variable rate debt, $50 million relates to the Term Loan against which we have applied the Interest Rate Swap. The Interest Rate Swap effectively fixes the
30-day
LIBOR rate at approximately 1.27% until maturity of the Term Loan. When factoring in the Term Loan as fixed rate debt through the Interest Rate Swap, approximately 85.9% of our debt was fixed rate debt and 14.1% was variable rate debt as of March 31, 2020. A 10% increase in LIBOR would increase our annual interest costs by approximately $0.1 million on debt outstanding as of March 31, 2020, and would decrease the fair value of our outstanding debt, as well as increase interest costs associated with future debt issuances or borrowings under our Unsecured Credit Facility. A 10% decrease in LIBOR would decrease our annual interest costs by approximately $0.1 million on debt outstanding as of March 31, 2020 and would increase the fair value of our outstanding debt, as well as decrease interest costs associated with future debt issuances or borrowings under our Unsecured Credit Facility.
Interest risk amounts are our management’s estimates based on our Company’s capital structure and were determined by considering the effect of hypothetical interest rates on our financial instruments. These analyses do not consider the effect of any change in overall economic activity that could occur in that environment. We may take actions to further mitigate our exposure to changes in interest rates. However, due to the uncertainty of the specific actions that would be taken and their possible effects, these analyses assume no changes in our Company’s financial structure. In addition, the uncertainty that exists with respect to the economic impact of the recent
COVID-19
pandemic has introduced significant volatility in global financial markets and economies subsequent to the three months ended March 31, 2020. The impacts of such volatility on the Company cannot be predicted with confidence or reasonably estimated at this time.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Based on the most recent evaluation, the Company’s Chief Executive Officer and Chief Financial Officer determined that the Company’s disclosure controls and procedures (as defined in Rules
13a-15(e)
and
15d-15(e)
under the Securities and Exchange Act of 1934, as amended) were effective as of March 31, 2020.
Management’s Report on Internal Control Over Financial Reporting
There have been no changes to our internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 1. Legal Proceedings
We and our subsidiaries are, from time to time, parties to litigation arising from the ordinary course of business. As of March 31, 2020, management does not believe that any such litigation will have a material adverse effect, individually or in the aggregate, on our financial position or results of operations.
The following risk factor supplements the risk factors disclosed in the section entitled “Risk Factors” of our Annual Report on Form
10-K
for the year ended December 31, 2019. Except as presented below or in the section titled “Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition” in this Quarterly Report on Form
10-Q,
there have been no material changes from the risk factors set forth in such Annual Report.
The current pandemic of the novel coronavirus
(“COVID-19”),
and the future outbreak of other highly infectious or contagious diseases, could have an adverse effect on our financial condition, results of operations, cash flow, ability to pay dividends and the per share market price of our common stock or preferred stock.
Since being reported in December 2019,
COVID-19
has spread globally, including to every state in the United States. On March 11, 2020, the World Health Organization declared
COVID-19
a pandemic, and on March 13, 2020, the United States declared a national emergency with respect to
COVID-19.
Since that time, the global impact of the outbreak has been rapidly evolving and, as cases of
COVID-19
have continued to be identified in additional countries, many countries, including the United States, have reacted by instituting quarantines, mandating business and school closures and restricting travel.
The
COVID-19
pandemic has had, and a future outbreak of other highly infectious or contagious diseases could have, repercussions across regional and global financial markets and economies. The outbreak of
COVID-19
in many countries, including the United States, has adversely impacted global economic activity and has contributed to significant volatility in financial markets.
Certain states and cities, including where we own properties and where our principal place of business is located, have also reacted by instituting quarantines, restrictions on travel,
“stay-at-home”
rules and restrictions on the types of businesses that may continue to operate. The Company cannot predict if additional states and cities will implement similar restrictions, whether or how the nature of these restrictions may evolve or when restrictions currently in place or modified restrictions in the future will expire. As a result, the
COVID-19
pandemic is negatively impacting many industries and governmental operations directly or indirectly, including the industries in which the Company and our tenants operate. A number of our tenants have announced temporary closures of their offices and other operations, and requested rent deferral or rent abatement during this pandemic. In addition, many of our employees in our principal offices are currently working remotely. The effects of an extended period of remote work arrangements, could strain our business continuity plans, introduce operational risk, including but not limited to cybersecurity risks, and impair our ability to manage our business.
The
COVID-19
pandemic, or a future outbreak of other highly infectious or contagious diseases, could also have adverse effects on our financial condition, results of operations, cash flow, ability to pay dividends and the per share market price of our common stock or preferred stock, among other factors:
| | • | a complete or partial closure of, or other operational issues at, one or more of our properties resulting from government or tenant action; |
| | • | the reduced economic activity severely impacts our tenants’ businesses, financial condition, liquidity and creditworthiness, which may cause one or more of our tenants to be unable to meet their obligations to us in full, or at all, seek modifications of such obligations or exercise early termination rights; |
| | • | a decrease in the demand for office space, which may have an adverse effect on our financial condition, results of operations and cash flow than if we owned a more diversified real estate portfolio; |
| | • | difficulty accessing sources of capital on attractive terms, or at all, impacts to our credit ratings, and a severe disruption and instability in the global financial markets or deteriorations in credit and financing conditions may affect our access to debt or equity capital necessary to fund future capital needs (including redevelopment, acquisition, expansion and renovation activities, payments of principal and interest on and the refinancing of our existing debt, tenant improvements and leasing costs) or refinancings on a timely basis and our tenants’ ability to fund their business operations and meet their obligations to us; |
| | • | the financial impact of the COVID-19 pandemic could negatively impact our future compliance with financial covenants of our Unsecured Credit Facility, including the Term Loan, and other debt agreements and result in a default and potentially an acceleration of indebtedness, whichnon-compliance could negatively impact our ability to make additional borrowings and pay dividends on our common stock or preferred stock; |
| | • | any impairment in value of our tangible or intangible assets which could be recorded as a result of a weaker economic conditions; |
| | • | a general decline in business activity and demand for real estate transactions could adversely affect our ability or desire to grow our portfolio of properties due to a lack of suitable acquisition opportunities; |
| | • | a general decline in the attractiveness of our properties due to changes in the demand for office space, which may adversely impact our ability to consummate pending or future dispositions on terms that allow us to recover expected carrying values of a real estate investment; and |
| | • | the potential negative impact on the health of a significant number of our employees could result in a deterioration in our ability to ensure business continuity or maintain adequate disclosure reporting or internal controls through the duration of this disruption. |
The extent to which the
COVID-19
pandemic impacts our financial condition, results of operations and cash flow, and those of our tenants, will depend on future developments, which are highly uncertain and cannot be predicted with confidence, including the scope, severity and duration of the pandemic, the actions taken to contain the pandemic or mitigate its impact, and the direct and indirect economic effects of the pandemic and containment measures, among others. In addition,
non-payment
of rent or early lease terminations by our tenants could reduce our cash flows, which could impact our ability to pay dividends to the holders of our common stock and preferred stock.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
On March 9, 2020, the Company’s Board of Directors approved a share repurchase plan authorizing the Company to repurchase up to $100 million of its outstanding shares of common stock. Under the share repurchase program, the shares may be repurchased from time to time using a variety of methods, which may include open market transactions, privately negotiated transactions or otherwise, all in accordance with the rules of the Securities and Exchange Commission and other applicable legal requirements.
Repurchased shares of common stock will be classified as authorized and unissued shares. The Company recognizes the cost of shares of common stock it repurchases, including direct costs incurred, as a reduction in stockholders’ equity. Such reductions of stockholders equity due to the repurchases of shares of common stock repurchased will be applied first, to reduce common stock in the amount of the par value associated with the shares of common stock repurchased and second, to reduce additional
paid-in
capital by the amount that the purchase price for the shares of common stock repurchased exceed the par value.
Share repurchase activity under our share repurchase plan, on a trade date basis, for the three months ended March 31, 2020, was as follows:
